An instruction manual on how to save money

I have recently found myself in something of a financial emergency. That is hard to admit since this is website is supposedly all about how I am good with money and have good ideas to share with you. But, the fact is I need to come up with a lot of cash quickly, so I am considering something that might not be such a good idea: a 0% credit card balance transfer. In this article we will look at the benefits, the potential problems, and what it really costs.

When a 0% balance transfer should be considered

1. A financial emergency

As I wrote about on my article on clarkhoward.com I recently quit my job where I had an outstanding 401(k) loan for about $16,000 that now must be repaid within a few months of the date I quit. On top of that, at just about the same time my roof started leaking and had to be replaced for another $7,000. Now I have a little bit of rainy day money set aside, but I can’t quite cover the whole $23,000. A financial emergency is one time when you should consider a 0% balance transfer.

2. When it is the cheapest loan available

Another time when you might want to consider a 0% balance transfer is when it has the lowest rate of any loan available to you. For example, maybe you have a 5% car loan. If you were able to pay off that whole car loan with your 0% balance transfer offer, then that might be a good idea. I have also used a balance transfer offer to pay off PMI in the past.

This should only be considered if you will absolutely without question be able to pay off your balance transfer before the 0% interest rate period ends. If there is any chance you won’t be able to pay the card off before then, the balance transfer is a horrible idea.

Free balance transfers aren’t free

Although under exactly the right circumstances the 0% credit card balance transfer might be a good idea, they should always be considered dangerous.

The first thing you should no about a 0% balance transfer is that they aren’t 0%. They almost always come with a fee that must be paid up front. Rarely you will find a card that comes with a fee of 0%, but 1% to 5% is more common.

For example, if you were to borrow $10,000 with a 3% fee and 0% interest at one year, make minimum payments of 1% of the balance for 1 year, then pay off the remaining balance in exactly 1 year before the 0% expires then your actual effective interest rate you are paying is more like 3.13%. That might be cheap, but it certainly isn’t free.

One way to come up with a rough estimate of the effective interest rate is to use this formula: (Percentage fee/ number of months*12). So a credit card that offers you 0% for 16 months with a 3% fee has an effective interest rate of about 2.25% (.03/16*12). Using a more complicated formula, I find the real effective interest rate is about 2.15%, but this simple formula should be accurate enough for most people to make an informed decision.

It’s a trap!

The next thing you should know about balance transfers is that they are a dangerous trap. They might look safe enough from the outside, but one false step and you pay big time.

The credit card companies have no intention of letting you borrow money at that low 0% fee. They know that most people will spring the trap and they will be able to charge those customers huge interest rates.

The first way they trap you is by tricking you into having more money than just the balance transfer money on the card. Let’s say you have a $1,000 balance on the card that you normally pay off each month at the time you transfer the balance. You just pay off the $1,000 with your next payment and everything is fine, right?

Nope! The credit card company will apply that payment you made to the amount you borrowed at 0%, not the amount of your purchases. So the amount being charged 0% is reduced, and you pay a sky high interest rate on your normal balance.

The same thing happens if you make a purchase at any time before you have your balance transfer paid off. If you are going to transfer a balance you absolutely must make sure there is no balance on the card before the transfer, make sure there are no automatic payments that will hit the card at any time, and make sure no purchases are made on the card until the balance transfer is paid off.

The second trap you have to look out for is the end of the 0% period. 0% is a cheap rate for a loan, and if you look at the real APR discussed above, that is also pretty cheap. But before long, that intro rate expires, and then you will be charged a rate that isn’t cheap at all. You will be charged the “normal” rate, which will be sky high. Maybe 25% or higher.

Let’s revisit the example above where $10,000 is borrowed at 0% for 1 year. If you make monthly payments of 1% for one year at the end of the year, your remaining balance will be about $9,130. That entire amount must be paid off before the 0% expires or you pay big time. If you forget to pay off that amount for just 1 month at a more “normal” interest rate of 20% then you will be charged over $150 just for one months interest!

You can’t afford to fall for that trap, so be absolutely sure the balance is paid off before the 0% period ends. I recommend taking the the date your period ends, choosing a date about 30 days before that date (just to be safe), and putting that date on your calendar as a reminder that your balance must be paid off. If you won’t be able to pay that amount off by that date, then the balance transfer isn’t for you. Just stop now and don’t do it.

Just to recap, here are the steps I recommend to avoid the credit card company’s traps. None of these steps are difficult or complicated, but all of them are critically important.

Steps to avoiding the credit companies traps

Make sure the balance on the card is $0 before you make the transfer.

Make sure there are no automatic payments that will be made on that card. This should also be done before the transfer.

Take the card out of your wallet and put it in your files somewhere. Don’t use this card to make a purchase under any circumstances until the balance transfer is paid off.

Make an entry on your calendar for about 1 month before the 0% interest rate ends.

Make a payment of at least the minimum amount each month. Do not be late! Setting up automatic payments is a safe way to do this.

Pay off the balance transfer balance in full before the 0% interest rate ends.

Have a big laugh at your credit card company’s expense. You just tricked them into making you a really cheap loan they had no intention of actually making you.

Credit card loans and your credit score

Another reason balance transfers aren’t such a great idea is that they might be bad for your credit score. A major factor in your credit score is how much of your available credit you actually use. If you have a total of $10,000 in available balance on your credit cards and normally have a balance of about $1,000 at the end of the month that you always pay off before the due date then your credit utilization rate is 10%. That is a good utilization rate and will help your credit score.

If you were to add a $5,000 credit card loan on top of that then your credit utilization score just became 60%. That isn’t good, and you can expect your credit score to take a hit. For more information on this, check out Quizzle

So should I do it?

So credit card loans can be cheap under the right circumstances, but they can also be dangerous. So what do you think, should I use a balance transfer to pay off my 401(k) loan, or is that following one bad idea with another bad idea?